Economic Insights - November 13 - 24, 2017

Quick takes: Growth in China is slowing, German politics may have found a balance, Japan’s economy is growing nicely, and confidence is surging in the United States. The only problem: when things can’t get any better, they usually don’t.

U.S. tax overhaul in process: Tax reform is center stage in Washington DC. The odds favor passage of simplified rules for individual taxpayers and reduction in corporate tax rates.

Economic quick takes

China slowdown:

Asia’s largest economy has slowed after a strong rebound from a stock market meltdown and currency misstep in 2015. Growth in the summer quarters decelerated moderately from a robust first-quarter pace, and October industrial activity slackened further. Output growth was 6.2% over the prior year, down from 6.6% in September. Retail sales were also weaker at 10.0% over a year ago, versus 10.3% in September. Property market activity is slowing and the pace of home price increases dropped to 5.7% over a year ago. The slowdown is partly purposeful because officials want to reduce the pace of debt growth. Yields on 10-year Chinese government bonds are already up to 4%. The official growth rate will likely slow to the low 6% range in 2018 with downside risk.

German politics:

For weeks, Chancellor Merkel has worked to build a coalition between her Christian Democrat bloc, the Free Democrats, and the Greens. That effort fell apart when the Free Democrats pulled out of negotiations. It appeared a minority government or new elections were ahead, plus more political uncertainty. That logjam may have broken after German President Frank-Walter Steinmeier encouraged Martin Schultz, leader of the Social Democrats (SPD), to participate in negotiations to form a second “grand coalition,” an alliance of the two largest parties. The SPD has the second most votes in the Bundestag and was Merkel’s partner in the last coalition.

Eurozone surges:

It’s the one region in the ongoing global economic expansion that may be picking up steam. In November, surveys of purchasing manager attitudes (PMI) hit the most robust levels of the cycle. The composite PMI for both service and manufacturing companies surged 1.5 points to a very strong 57.5 (50 is the neutral level between expansion, contraction). Consumer confidence rose to another 17-year high and German business attitudes are record high. Third-quarter growth was revised up to 2.5%. Current PMIs suggest upside risk to growth.

Japan growing:

Third-quarter growth was reported at 1.4%, down from the prior quarter’s 2.5%, but, still surely above potential for a country with a declining population. PMIs are trending higher and wage growth, while still anemic, shows evidence of picking up. Unemployment is an incredibly low 2.8%. Signs of inflation are mounting; the producer price index surged 3.4% over the prior year, one of the biggest jumps in the country’s history.

Surging U.S. confidence:

Whether it’s consumers, homebuilders, small businesses, or investors, confidence is near record levels. It’s no wonder: the job market is robust, wage gains are gathering speed, capital spending is rapidly expanding, consumer net worth is reaching record-highs, house prices are rising, housing starts and sales are trending up. All this data suggests the U.S. economy has several more quarters of sustainable expansion ahead.

If things can’t get any better:

They usually don’t, and that will eventually be a problem. With economies in China and Japan already past their peak momentum and the United States likely at its peak this quarter or next, the news can’t get much better. We would expect to see confidence measures max out in the near term and some mild deceleration set in mid to late 2018. It’s not a sign of recession, it’s just that cycles don’t last forever. Expect long-term yields to try to normalize higher and financial markets to be more volatile.

U.S. tax overhaul in process

On November 16, the House of Representatives passed its version of U.S. tax code reform called the “Tax Cuts and Jobs Act” (TCJA). The TCJA is structured around cuts in corporate and “pass through1” tax rates, but also contains a broad array of changes in individual rates and allowable deductions. The House version will go to a Senate-House conference committee if the Senate passes its version of reform. Because few Democrats will vote for reform, the bill must add no more than $1.5 trillion to the deficit over 10 years to qualify under legislative rules that allow passage with a bare majority in the Senate. The bill is premised on the desire for a permanently lower corporate tax rate to make U.S. businesses more competitive and incentivize them to bring foreign earnings back to the Unites States to be invested. That rate cut alone is estimated to lower federal revenues by nearly the full $1.5 trillion allotment. So, now comes the battle for additional revenue in the form of eliminating some deductions, each of which is precious to one constituency or another.

Here are some key provisions of the TCJA for business with Senate differences noted:

A permanent cut in corporate tax rates from 35% to 20%, with effective date 2018 in the House and 2019 in the Senate.

Corporate earnings would be taxed principally in the country where earned, excluding a small surcharge imposed on foreign earnings.

A one-time tax on repatriated earnings of 12% on cash and 5% on illiquid assets.

Earnings from pass throughs and small business would be taxed at a lower rate than the current individual rate, although House and Senate versions differ. Professional corporations set up by, for example, doctors or lawyers would not qualify for lower rates.

Corporations and pass throughs would be able to fully and immediately expense equipment purchases for the next five years, but would face the loss of other deductions.

The Senate version repeals the individual mandate to purchase health insurance under the Affordable Care Act.

For individuals, a highly abbreviated list of major proposed tax law changes are as follows:

Personal tax rates would be lowered and there would be fewer brackets in the House with the same top rate of 39.6%. Rates in the Senate would lower with a top rate of 38.5%.

The personal exemption would be repealed, but the standard deduction and child tax credit would be roughly doubled.

The estate tax exemption would double to $11.2 million per individual and be repealed by the House in 2024.

The alternative minimum tax would be repealed.

Some individual deductions would end, but some charitable deductions would remain. The deduction for state and local property, sales and income taxes are eliminated in the Senate version and limited to $10,000 in the House. The latter permits deduction of interest for mortgages up to $500,000; the Senate uses a $1,000,000 limit, both for primary residences only.

The House bill repeals most education related deductions while the Senate retains most. The latter imposes a 1.4% excise tax on net investment income for certain large, wealthy private colleges and universities.

The interest on tax-exempt bonds issued by cities to finance sports stadiums would no longer be deductible.

Retirement plan deductions would remain relatively untouched.

The loss of federal revenue over 10 years is estimated to be $1.472 trillion, net of off-sets. Although the House and Senate versions contain many differences, the revenue lost is essentially the same in both.

Could it pass?

There is a lot of resistance to such proposals, especially the repeal of the individual mandate and the loss of deductions for state and local sales and income taxes by individuals living in high-tax states. Markets seem to give a greater than 50% chance of passage. The odds likely depend on how much the House and Senate bills have in common and there are very significant areas of overlap, most of which are noted above. The more consistency there is, the greater the odds of passage.

There will be plenty of sticking points, including repeal of the individual mandate as well as limiting deductions for mortgage interest and state and local sales, property, and income taxes. Then there is the so-called “bubble tax”: a surcharge for wealthy tax filers that raises the rate paid on part of their income well above the 39.6% top rate. The question is whether both houses of Congress are willing to compromise to reduce business taxes, make some initial steps to simplify the tax code, bring foreign earnings back to the United States to be invested locally, and raise productivity and growth for the U.S. economy. We think the odds favor passage yet this year.

1 “Pass through” entities are S-Corporations, limited liability companies, partnerships and sole proprietorships where income flows through the business to be taxed at the individual tax rate of the owners. An S-corporation is generally a closely held corporation that is organized under Subchapter S of Chapter 1 of the U.S. Internal Revenue Code.

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